Financing Start-Up Dreams With Retirement Savings

BOHNNE JONES had always dreamed of being an architect or interior designer. Suzie Ford wanted to know if the home-brewed beer her husband, Todd, made was as good as people said it was, while Jan Morris figured owning a distillery would be more fun than being a divorce lawyer.

They had three very different dreams, but these women had one thing in common: they all lost jobs and decided to use sizable retirement accounts to start their own businesses in very different fields. They did so by converting traditional 401(k) accounts into new retirement plans — known as “rollovers as business start-ups,” or ROBS — that they could invest in their companies.

“It’s fueled by the fact that stock market has returned to all-time highs, real estate is up, consumer confidence is up — but we’re also suffering from a credit crisis, and unemployment remains high,” said David Nilssen, chief executive of Guidant Financial, which specializes in helping people use 401(k) assets to invest in businesses or other nontraditional assets, like property. “People look at this because they can capitalize a business without taking on any debt.”

While this may sound like an easy solution to finance a company, it is incredibly complicated, and the risks of running afoul of the Internal Revenue Service or the Department of Labor, which has jurisdiction over 401(k) plans, are significant. The worst possible outcome is a triple-whammy loss of a person’s retirement savings, the business and a source of income if the idea fails.

Adding to the complications, ROBS exist in a parallel financial universe, where those who promote the plans see them as solutions for retirement-rich but cash-poor entrepreneurs, while many other financial advisers see the plans as treading the line of legality.

“The I.R.S. has said that they don’t view them as tax-avoidance schemes per se,” said Carol J. Ventura, retirement specialist at H.D. Vest, a broker-dealer with $33 billion under management. “They’re not illegal, but the I.R.S. is saying that they have to be perfectly put in place. They’re very complicated.”

Failure to do everything right could lead to anything from penalties to having the entire retirement plan disallowed, which would mean a big tax bill.

Still, Mr. Nilssen said the idea had been gaining in popularity. He said his company had its best year in 2012 with 1,300 new ROBS and expects to do 1,700 this year. I wanted to know what the attraction was to something that seemed so complicated and magnified the sizable risk of starting any business.

Here’s how ROBS work: People take their 401(k) account (or other qualified retirement plan) and roll it over into a new plan that buys shares in an operating company that will own their business. Unlike most small businesses, which are set up as limited liability corporations or S-corporations, a business financed through ROBS has to be a C-corporation, which can issue shares and does not prohibit ownership by trusts.

In many cases, people turn to ROBS because they don’t have other sources of financing and have not been able to secure a small-business loan.The companies of the people I spoke to were owned by anywhere from 90 percent of one person’s 401(k) to 100 percent of two entire plans.

That might sound simple, but what effectively happens is that the plan, not the person, owns the business. That means the person cannot act in his best interest but must act in the best interest of the plan. For example, if he wants to give himself a raise, he needs to find out what similar business owners make.

“I have counseled people on how to do them correctly and then I typically say, ‘I find it to be a bad idea and you’re probably going to get yourself in trouble,’ ” said Bill Smith, a tax lawyer and managing director in the CBIZ National Tax Office. “The I.R.S. is not consistent on what it considers correct. It’s very easy to mess these things up.”

Mr. Nilssen said Guidant helped people set up the initial plan and managed the reporting requirements. He said that of his firm’s 8,500 clients, about 50 had been audited, but none had had action taken against them.

Ms. Jones said that in the course of putting $260,000 of the $340,000 she had in her retirement account into buying a Decorating Den franchise in Nashville, she had several lean years during the recession, but that she is now doing well. She says she is also happier than when she was working in health care technology.

But she said the paperwork to comply with the I.R.S. rules could be complicated — and managing paperwork was part of her previous career. One requirement of these plans is that she and any employees pay into the 401(k) set up to buy the company. “That check has to be out the door seven days after payroll,” she said. “If I’m late at writing a check to deposit my 401(k) money, there are penalties, and I’ve paid penalties.”

There are worse ways to run afoul of the law. Mr. Smith pointed to a recent United States Tax Court case, Peek v. Commissioner, where the business owners used their retirement accounts to buy a fire and safety firm and later sold it at a significant profit. The court, however, declared that their gains were taxable because they had also secured loans with their homes to buy the business. While this is something small-business owners do regularly, it is a prohibited transaction under I.R.S. guidelines for ROBS.

And people had better be confident this structure is right for them. Unwinding a business created through ROBS, so that the gains or losses do not have to go back to the retirement plan, may not be possible without a sale to a third party or a total loss, said Ms. Ventura. The I.R.S. rules are just too strict.

But considering the enthusiasm anyone has going into a new business, particularly after years of not being terribly happy in a job, it is not surprising that details get overlooked. Ms. Morris, 61, said that after she was laid off as a lawyer, she and her husband, 63, helped their son start a brewery, and that “he was having a good time with his brewery, so I thought I could do a distillery.”

After taking a weeklong course in distilling spirits, she got excited about the idea and had begun applying for a small-business loan when her bank suggested she talk to Guidant. Now, she said, the couple had put 100 percent of both of their 401(k) accounts into the Hardware Distillery in Hoodsport, Wash., about two hours outside of Seattle.

Asked how she felt about such concentrated risk in their 60s, she said, “I think it’s all going to come out O.K. in the end.” If it doesn’t, she added, they at least own the building.

Mr. Nilssen said his firm did not counsel clients on how much of their retirement accounts to use. But to critics who say that ROBS are used primarily by older, less sophisticated entrepreneurs, he said: “People are coming to us after they’ve built their idea, found a franchise, or secured a business to buy. We don’t get into whether or not someone should be an entrepreneur.”

This is where having independent legal and tax counsel is important for anyone thinking of ROBS.

Scott Hanson, principal at Hanson McClain, which manages $1.6 billion, said he was generally against the idea of tapping a retirement account to invest in a business beyond taking a loan out against a 401(k), which is capped at $50,000. If people needed more, he said, they would be better off taking the money out, paying the income taxes — and a 10 percent penalty if they’re under 59 ½ — and setting up an S-corporation that would allow them to take any losses on their tax return, which is something they cannot benefit from by owning a business through a retirement plan.

“Maybe I’m biased because I’ve seen situations where people have drained their retirement account down to nothing and the business fails,” he said.

Even if everything goes well, selling the business is not as simple as it would be if the person owned it outright. Since the 401(k) plan owns the business, the person who benefits from the plan has to have the business valued and sell if for fair market value.

“It’s so complex that I’ve put it out of my head,” said Ms. Jones, who is 62 and plans to work until she is 70. She said she hoped her employee would want it. “I told him that if he stayed that long he can have it, but you can’t legally do that. And I can’t sell it to him for $1 either because the I.R.S. won’t allow this.”

Until that point, though, if the business is successful it can be enjoyed like any other good investment.

Ms. Ford, a former community banker, and her husband, Todd, a former airline pilot, used all of their 401(k) accounts and also took out an equipment loan to start the NoDa Brewing Company in Charlotte, N.C. But they have used cash flow to expand the business three times since founding it in 2011.

“We truly believed in what we were doing and understood how risky this was,” said Ms. Ford, 46. “We did the market research. We hired a great team. We surrounded ourselves with good people.”

She added, “Worst-case scenario, we would go off and get other jobs, but we just tried not to focus on that.”

Two years into the venture, their beer is now served at 325 sites including the major sporting arenas in the city. “We have good, consistent beer and that’s the difference,” she said. If only it were that simple.

A version of this article appears in print on , Section B, Page 5 of the New York edition with the headline: Financing Start-Up Dreams With Retirement Savings. Order Reprints | Today’s Paper | Subscribe